Disclaimer: Any opinions expressed, potshots taken, or scientific views articulated are mine, and need not represent the opinions, potshots, or scientific views of the Federal Reserve Bank of St. Louis, or the Federal Reserve System.

Thursday, October 13, 2011

Twisting

Bernanke and other Fed officials like to tell us about the large toolbox they have available for fixing what ails us, and the meeting began with a discussion of the available tools that could be used to supply more accommodation. The choice was framed as Goldilocks would see it. There is "too cold," "just right," and "too hot," in that order, and you know at the outset that the committee will choose just right.

Too cold would involve a change in how the proceeds from principal payments on its holdings of agency securities would be revinvested. Policy before the last meeting was to hold the size of the Fed's balance sheet constant, and to take the proceeds from agency securities and mortgage-backed securities (MBS) that run off, and reinvest that in Treasury securities with a particular average maturity. The proposal was to simply lengthen that average maturity. Just right was Operation Twist - lengthen the average maturity of the Fed's portfolio by selling short-maturity Treasury bonds and buying long Treasuries, while holding the size of the balance sheet constant. Too hot was a repeat of QE3 - an increase in the size of the Fed's balance sheet through purchases of long Treasuries.

At this point in the meeting, there is some discussion. People on the committee who are in an accommodative mood are thinking they will want to keep trying if whatever the committee decides to do now does not work. Just right is seen as a one-time intervention - clearly you can't keep increasing the average maturity of the Fed's portfolio indefinitely. Some people raise some objections: maybe none of these interventions will have much of an effect, if any; maybe we will get too much inflation. A proposal is introduced which was not heretofore on the table (and which ultimately the committee will go for), which is to reinvest the proceeds from maturing agency securities and MBS in more MBS, rather than in Treasuries.

Then, there is a discussion about transparency. In particular:

Most participants indicated that they favored taking steps to increase further the transparency of monetary policy, including providing more information about the Committee's longer-run policy objectives and about the factors that influence the Committee's policy decisions.

It's hard to know what to make of this without more specifics. Maybe what the committee members had in mind was in line with what Evans talks about here. If so, it's wrongheaded, and some people on the committee seem to think so too:

a number of participants expressed concerns about the conceptual issues associated with establishing and communicating explicit longer-run objectives for the unemployment rate or other measures of labor market conditions, inasmuch as the long-run equilibrium levels of such measures are influenced importantly by nonmonetary factors, are subject to change over time, and are estimated with considerable uncertainty. In contrast, participants noted that the long-run level of inflation is determined primarily by monetary policy.

The committee also considered the possibility of lowering the interest rate on reserves (IOR), presumably to 0% from 0.25%. It is quite important that this discussion appears in the FOMC minutes, as decisions about changes in the IOR actually rest with the Board of Governors, not the FOMC. In discussing this at the FOMC meeting, the Board is recognizing that the committee should have a role in the decision, though that role was not given to it by Congress. In my view, a change in the IOR, or language that tells us about the future path of the IOR, is the only relevant element of Fed decisionmaking currently. None of the quantitative interventions actually matter, under current circumstances.

Here is a useful piece of information from the IOR discussion:

a recent change in deposit insurance assessments had the effect of significantly reducing the net return that many banks receive from holding reserve balances.

There are some seemingly puzzling things going on with respect to the behavior of the fed funds rate relative to the IOR. One might expect that the IOR would place a lower bound on the fed funds rate, much as in any channel system (Canada, Australia, ECB, for example). But this is not the case, as the fed funds rate is currently less than the IOR, and has even decreased since late 2008. The GSEs (Fannie Mae, Freddie Mac) do not receive interest on reserves, and commercial banks do not arbitrage away the difference between zero and 0.25%, for reasons that are in part unexplained. However, a contributing factor to the lack of arbitrage has been the change in deposit insurance assessments. Banks are now charged the assessment based on total assets, not deposits. Thus, if I am a bank and attempt to arbitrage the difference between the fed funds rate and the IOR by borrowing on the fed funds market and holding what I borrow as reserves, I increase what I pay to the FDIC. As well, there seems to be some effect of the total quantity of reserves in the system on the IOR-fed funds rate differential (higher reserves increases the differential), but this is just a correlation with no theory backing it up.

Otherwise, the IOR discussion is a bit murky. For example:

Moreover, many participants voiced concerns that reducing the IOR rate risked costly disruptions to money markets and to the intermediation of credit, and that the magnitude of such effects would be difficult to predict in advance. In addition, the federal funds market could contract as a result and the effective federal funds rate could become less reliably linked to other short-term interest rates.

The "disruptions to money markets" may refer to effects that might arise because of the rules governing money market mutual funds, but I'm not sure. I'm not sure why anyone is concerned with activity on the fed funds market. Most of the activity on this market currently must simply be commercial banks borrowing from GSEs. Why do we care if that goes away?

The FOMC of course settled on a policy involving a swap of $400 billion in short-term Treasuries for an equal quantity of long-term Treasuries ("Operation Twist"), and a policy of reinvesting principal repayments on agency securities and MBS in new MBS. The committee members voting for these measures seem to think this will result in decreases in long-term interest rates, and a reduction in the margin between mortgage rates and other long-term interest rates.

There were of course three dissenting votes. Fisher's objections were:

Mr. Fisher saw a maturity extension program as providing few, if any, benefits in support of job creation or economic growth, while it could potentially constrain or complicate the timely removal of policy accommodation. In his view, any reduction in long-term Treasury rates resulting from this policy action would likely lead to further hoarding by savers, with counterproductive results on business and consumer confidence and spending behaviors. He felt that policymakers should instead focus their attention on improving the monetary policy transmission mechanism, particularly with regard to the activity of community banks, which are vital to small business lending and job creation.

The first sentence makes sense, but I can't decipher the rest. Hoarding by savers and improvements in transmission through community banks? What's that about? We know Fisher is not an economist, but he has economists briefing him. Does he not listen? Does it not sink in? Are the briefers bad at their jobs? Who knows?

Kocherlakota says:

Mr. Kocherlakota's perspective on the policy decision was again shaped by his view that in November 2010, the Committee had chosen a level of accommodation that was well calibrated for the condition of the economy. Since November, inflation, and the one-year-ahead forecast for inflation, had risen, while unemployment, and the one-year-ahead forecast for unemployment, had fallen. He did not believe that providing more monetary accommodation was the appropriate response to those changes in the economy, given the current policy framework.

Mr. Plosser felt that a maturity extension program would do little to improve near-term growth or employment, in light of the ongoing structural adjustments and fiscal challenges both in the United States and abroad. Moreover, in his view, with inflation continuing to run above earlier forecasts, such a program could risk adding unwanted inflationary pressures and complicate the eventual exit from the period of extraordinarily accommodative monetary policy.

I think that is basically correct, but the maturity swap is essentially irrelevant for inflation, and does not further complicate exit, given that the size of the balance sheet is being held constant.

So, the majority of voting members on the FOMC seem to think that they can actually do things that are more "accommodative" currently. Even the people who are objecting (particularly Plosser) seem to think that the Operation Twist maturity swap, and the QE2 swap of reserves for long Treasuries, actually matter for long-term interest rates. If the Fed can in fact move long-term interest rates at will, then in fact they should be able to target long-term nominal interest interest rates. Indeed, if we believe what the FOMC says, the Fed should be able to determine the whole nominal term structure of interest rates by intervening sufficiently. Why then are these unusual interventions specified not as interest rate targets but in terms of the quantities of assets purchased? You know why. If they thought they could hit the interest rate targets, they would announce it that way. But they know they cannot; basically it doesn't work.

28 comments:

"Why then are these unusual interventions specified not as interest rate targets but in terms of the quantities of assets purchased? You know why. If they thought they could hit the interest rate targets, they would announce it that way. But they know they cannot; basically it doesn't work."

They probably could hit many of the rates along the nominal Treasury yield curve as desired - with some kind of medium sized ball-park around them - but are concerned that such a policy would lead to a $10 trillion balance sheet...and a complete monetization of US debt for next year and longer.

The Fed is probably going to increase IOR when it feels it has to tighten. Selling all these securities would likely cause major losses as interest rates would be higher that such a point in time. Thus, a large portion of the US debt is going to be monetized should the Fed purchase $10 trillion worth of Treasury securities.

Well, clearly they say that they can move "many of the rates along the nominal Treasury yield curve." If they were confident about the effects, they would tell us how much, and commit to the rate movement.

Yes, whether that's a better question I'm not sure, but that is important too. You announce something explicit (not what, for example, Evans has in mind) - a target for the inflation rate, or a price level target path - then there is the question of how you implement that, usually through some short-run target for an overnight nominal interest rate. Under current Fed policy, the ultimate goal(s) is implicit, and the short run target is not even implicit. I don't think the people on the FOMC understand what it is, let alone anyone else.

"Yes, mind you the gap existed before the new FDIC rules and never got arbitraged away."

Yes, exactly. The gap has been there since the Fed has been paying interest on reserves. The gap got larger, apparently because of the FDIC rules, and maybe because of the increase in the quantity of reserves in the system.

"In short, the theory is it could cause severe problems in the repo market."

I'm beginning to think this disruption story is nonsense. This might indeed be "disruptive" in some sense for people who run mutual funds or engage in the repo market - they will have less business or none at all. However, socially I don't think we should care, i.e. the Fed should not care.

"The Fed set t-bill rates from 1942-47 and long term gov bond rates from 1942-51, no?"

I don't know enough about the pre-Accord period to understand what they are doing. Certainly if the Fed buys all of a particular maturity of T-bonds, they can set the price. I don't know if that was what was going on. In any case, if they can peg bond rates, why don't they do that?

"Why then are these unusual interventions specified not as interest rate targets but in terms of the quantities of assets purchased? You know why. If they thought they could hit the interest rate targets, they would announce it that way. But they know they cannot; basically it doesn't work."

Respectfully... h0r$e$hi+, Steve.

There are a host of potential reasons why the FOMC hasn't tried to "fix" long rates. For one thing, I suspect that the FOMC is afaid of being accused of monetizing the debt -- or actually doing it. And they don't want to get into a situation where they reduce the liquidity of the Treasury market. So the FOMC might limit the Q up front to avoid an open-ended Q commitment.

Doing QE was a big enough step, now you accuse them of mendacity because they didn't do enough.

I know at least one fairly prominent ranking economist at a major (non-US) central bank who wanted to start moving out on the yield curve, pushing rates down as we went. He had no doubt that it would "work" and you definitely would know him.

No one who has looked at the event data thinks that the QE purchases didn't "work." And if you think that the event effects are obviously systematically reversed then you must think that markets are remarkably inefficient because then there are HUGE profit opportunities.

The last time that we had this argument you said that I needed a model to conclude that QE affected the economy. My response was that it would be a strange model in which changes in real asset prices did not affect the economy.

Now you're going further and denying the real asset price effects. Go look at the data. 10-year Treasury yields fell by about 100 bp around the first round of QE announcements and inflation expectations rose by almost as much.

If you've read them, thoughts? Don't feel compelled to read them if you haven't of course, I know you're busy. Just figured they would interest you. They show how silly it is to think freshwater macro is dead.

The question about targeting prices vs. quantities reminds me of a similar discussion in environmental economics, namely whether it is best to use cap and trade vs. carbon tax.

Weitzman has some work on the issue. This is the seminal paper, I think:

http://www.jstor.org/stable/2296698

Basically it has something to do with what is the nature of the uncertainty faced by the planner. I guess you could say that under this framework targeting quantity is an admission of uncertainty in some dimension. But it is not enough grounds to dismiss it as a policy strategy.

"Josh, these papers show how silly it is to even talk about freshwater macro. What makes them freshwater? The fact that they don't have price rigidities? Is that the dividing line?"

That's probably a more sensible way to look at things, yes! I'm not particularly fond of the labels either... but they do get tossed around often enough, and sticky prices are indeed the dividing line the great bulk of the time. But again, you're right- I mean one of the papers is basically just Smets/Wouters plus calibration and minus the sticky prices.

There is a piece of modern macro - New Keynesian economics - that, while it might seem small in terms of actual progress made, looms large in some minds. The rest of modern macro is very much alive, with plenty of people thinking about problems and frictions that have nothing to do with sticky wages and prices. If anyone is claiming that "freshwater macro," whatever that is, is dead, they should remember the old Mark Twain quote. Something like "Reports of my death are an exaggeration." I have seen the Jermann/Quadrini paper, but not the other two. J/Q is interesting - interesting take on some features of the data, though the friction is a bit on the ad-hoc side.

Bloom has been trying to push the notion that changes in uncertainty matter for macro aggregates. This is vaguely within the "saltwater"/keynesian tradition in that you could think of uncertainty shocks as something close to expectations shock and somehow "demand"/animal spirits related.

Quadrini's agenda is to explore the consequences of financial frictions. Focus on financial disfunction is also a mainstay of saltwater/keynesian traditions although before the crisis it has been neglected by the Woodfordian sticky price literature. Now Woodford and all the others are being very quick to embrace it.

Finally, Quadrini and Perri have multiple equilibria built in somewhere as a foundation for the shocks in their model (although I haven't quite figured out how or why exactly it works). Nothing could be more keynesian than that.

Having said all that, none of the papers has sticky prices, all of them use calibration approaches and, in much of Bloom's work there is no market failure to be seen.

You seem to have uncovered some of the best examples of why the saltwater/freshwater divide is not very helpful.

Fisher's comment isn't crazy I think. Suppose the Fed can really lower long term real rates (at least for a while). It isn't obvious that everyone will increase consumption. Suppose you are saving for retirement - you might choose to save more with lower rates. In a simple 2 period life-cycle model with log preferences, no discounting, and a fixed endowment in the first period only, you save half the endowment irrespective of the interest rate. I'm not sure if someone has figured this out for a carefully calibrated OG economy.

wrong again. Fed could indeed target long term rates if it chose to (I worked on a trading desk).Fed already targets the funds rate. Just the fact that the Fed annnounced such a target would do most of the work. Even though it could, its not necessarily a good idea. Targeting nominal long terms rates presents a whole host of issues such as the fact that much corporate and MBS and other assets are indexed off the 5 & 10 year treasury. The Fed and other market participants would lose a significant amount of information on financial conditions, inflation and the state of the economy by targeting the 10 yr rate. I have mixed feelings about it - it might be ok in the short term but then how do you exit this policy?

I do agree that the maturity swap exercise is not going to do much. Anyway, low rates are not really the problem right now.